Finance

Book: Corporate Finance

Chapter 1

1. a. Capital Budgeting

The process of planning and managing a firm’s long-term investments is called capital
budgeting.

In capital budgeting, the financial manager tries to identify investment opportunities that
are worth more to the firm than they cost to acquire.
Loosely speaking, this means that the value of the cash flow generated by an asset exceeds
the cost of that asset.

b. Goals of Capital Budgeting

 Financial managers must be concerned not only with how much cash they expect to
receive,
 But also when they expect to receive it,
 How likely they are to receive it.
 Evaluating the size, timing, and risk of future cash flows is the essence of capital
budgeting.

c. Example: For a large retailer such as Walmart, deciding whether to open another store
would be an important capital budgeting decision.

d. Clarification: Some decisions, such as what type of computer system to purchase, might
not depend so much on a particular line of business.

2. a. Capital Structure

A firm’s capital structure (or financial structure) is the specific mixture of long-term debt and
equity the firm uses to finance its operations.

 Concern 1: What mixture of debt and equity is best?

 Concern 2: The mixture chosen will affect both the risk and the value of the firm.
 Concern 3: What are the least expensive sources of funds for the firm?
 Concern 4: What percentage of the firm’s cash flow goes to creditors and what
percentage goes to shareholders?

b. Goals of Capital Structurization

 Deciding whether one structure is better than any other for a particular firm is the
heart of the capital structure issue.
 The financial manager has to decide exactly how and where to raise the money.
 The expenses associated with raising long-term financing can be considerable, so
different possibilities must be carefully evaluated.
  Choosing among lenders and among loan types is another job handled by the
financial manager.

c. Example: If we picture the firm as a pie, then the firm’s capital structure determines how
that pie is sliced.

3. a. Working Capital Management

The term working capital refers to a firm’s short-term assets, such as inventory, and its
short-term liabilities, such as money owed to suppliers.
Managing the firm’s working capital is a day-to-day activity that ensures that the firm has
sufficient resources to continue its operations and avoid costly interruptions.
This involves a number of activities related to the firm’s receipt and disbursement of cash.

b. Problems that are solved

 How much cash and inventory should we keep on hand?

 Should we sell on credit?
 If so, what terms will we offer, and to whom will we extend them? How will we
obtain any needed short-term financing?
 Will we purchase on credit, or will we borrow in the short term and pay cash?
 If we borrow in the short term, how and where should we do it?

4. Forms of Business Organizations

Sole Proprietorship Partnership Corporation

Gets the total earnings Earnings divided among the Earnings distributed among the
partners stockholders according to the
hierarchy
Relatively easy to establish Relatively easy to establish Quite lengthy and complex
process of establishment
Legal requirements are minimal Legal requirements are moderate Legal requirements are complex
Complete control over the Control over the business is No individual has total control
business shared over the business, rather a board
control it
Subject to lower taxes Subject to lower taxes Subject to higher taxes
Incurs the total loss Losses are shared The most stockholders can lose is
the amount invested
Unlimited liability Unlimited liability Limited liability
Limited access to funds Additional funding from partners Easy access to funds
Unable to control all parts of the Able to control most parts of the Able to control all parts of the
business business business
Reach a number of few customers Reach a variety of customers Reach a wide number of
customers
Transfer of ownership is a Transfer of ownership is quite Transfer of ownership is relatively
mediocre process complex easier
Data stays with the owner Data is shared within Partners Public disclosure of data
The owner is the only boss Potential conflict of interests Agency problems
Notes:

1. A Limited partner’s liability is limited to the amount he contributes, for example: A limited
partner in a real state venture.
2. Sole Proprietorship and Partnership businesses have limited life or timespan.
3. LLCs are operated and taxed like a partnership, but retained liability for owners.

5. a. Goals of Financial Management

 Survive.
 Avoid financial distress and bankruptcy.
 Beat the competition.
 Maximize sales or market share.
 Minimize costs.
 Maximize profits.
 Maintain steady earnings growth.

b. A Financial manager’s ultimate goal is to Maximizing stockholder’s value or his wealth.

 The goal explicitly refers to maximizing current stock value avoiding the short term
and long-term concerns.
 Stockholders receive what remains after all other stakeholders, thus Stockholders
are residual owners.
 Corporate finance is defined as the study of the relationship between business
decisions and the value of the company's stock, emphasizing its central role in
financial management.

c. The General goal:

Maximizing the market of value of the existing owners’ equity.

6. a. Agency Problem

Agency Relationships: The relationship between stockholders and managers

Conflicts of interests between the principal and the agent is called agency problem.

b. Management Goals

 Investors might be willing to take risk, but managers won’t, because they might lose
their jobs.
 An agency cost, is a lost opportunity because of the conflict between Stockholder
and Manager.
 There are two types of agency costs. Direct and Indirect.
  An indirect agency cost is just the example mentioned above.
 Direct one refers to luxurious expenditure or hiring external auditors to assess firm’s
financial management.

c. What to do if Managers do not act in Stockholders’ interest?

 Managerial Compensation: Offering them stocks at a bargain price.

 Control in the firm: Replacing managers or Stockholders, if necessary, even by the
means of Proxy Fight (A mechanism to replace existing management)

Note: Stakeholders are employees, customers, suppliers and even the government who
have financial interest in the firm.

7. The Hierarchy

7. Financial Markets
In financial markets, debt and equity securities are bought and sold.

a. Primary Market

 Seller: The Corporation. The transaction raises money for the corporation. Two types
of transaction:
o Public Offerings: Involves selling securities to general public
o Private Placement: Involves negotiated sale to a specific buyer

Basically, refers to stock market.

b. Secondary Market

Transaction involves one owner or creditor two another one. Two kinds of Secondary
Market:

 Dealer Market: Dealer buy and sell at their own risk, like simply a car dealer. The
brokers match the buyer and seller. They do not own the property, like a real estate
agent.
 Auction Market: Different in two ways.
o It has a physical location, like Wall Street.
o It matches sellers and buyers directly.

Note: Stocks that trade on an organized exchange are said to be listed on that exchange.

8. Cash Flows

a. Cash Flows between the firm and the financial markets

b. Free Cash Flows

  Free cash flows are the cash flows that are available (or free) for distribution to all
investors (Stockholders and Creditors).
 FCF = Sales revenues – (Operating costs + Operating taxes + Required
investments in operating capital)

c. Managerial Actions to Maximize Shareholder’s Value

 Amount of expected cash flows (Bigger is better)

 Timing of the cash flow stream (Sooner is better)
 Risk of the cash flows (Less risk is better)

The cash flows that matter are called Free Cash Flows (FCF).

d. What determines a firm’s fundamental, or intrinsic value?

Intrinsic (Fundamental) value of a firm is the sum of all the future expected free cash flows
when converted into today’s dollars.

e. Over the Counter Markets

 In the old days, securities were kept in a safe behind the counter and passed over
the counter when they were sold.
 Now the OTC market is the equivalent of a computer bulletin board.
 Potential buyers and sellers post an offer in the bulletin
 No dealers
 Very Poor Liquidity

f. Conflicts between Stockholders and Bondholders

 Stockholders prefer risk and return.

 Bondholders are concerned about the use of additional debt.
 Bondholders attempt to protect themselves by including covenants in bond
agreements that limit the use of additional debt and constrain manager’s actions.

g. Weighted Average Cost Capital (WACC)

WACC is the average rate of return required by the investors, and is affected by:
 Capital Structure
 Interest Rates
 Risk of Firm’s Operations
 Investors’ attitude towards risk

h. Financial Decisions

 Investment
 Financing
 Dividend

i. Becoming a corporation

 Charter: Get registered with information like name, activities, amount of stock,
number and directors.
 Bylaws: Setting some bylaws specific for the firm.

8. a. Cost of Money

 Interest Rate = The price, or cost of, of Debt Capital

 Cost of Equity = Required Return = Dividend Yield + Capital Gain
 Certain economic, and international factors and conditions affect the cost. Such as:
o Production opportunities
o Time preferences for consumption
o Risk
o Expected Inflation
 Economic Conditions affect cost of money as well:
o Federal Reserve Policies
o Budget Deficits
o Level of Business Activity (Recession or Boom)
o International Trade Deficits
 International Conditions
o Country’s economic, social and political environment’s risk
o Exchange rate risk which is affected by the above factors
9. a. Transfer of Capital from Savers to Borrowers:

b. Financial Institutions

 Savings & Loan Associations

 Credit Unions
 Commercial Banks
 Investment Banks
 Investment Funds
 Private Equity Funds
 Life Insurance Companies
 Pension Funds

c. Financial Securities

Money Market: T-Bills, CD’s, Eurodollars, Fed Funds (Debt Securities)

Capital Market: T-Bonds, Agency Bonds, Municipals, Corporate Bonds (Debt Securities),
Common Stock, Preferred Stock (Equity Securities)